Fed decision: Recovery losing steam

The Fed announced that it will make additional Treasury purchases and maintain the near-record amount of securities it holds.By Chris Isidore, senior writerAugust 10, 2010: 4:22 PM ET

NEW YORK (CNNMoney.com) -- The U.S. economic recovery is weakening, the Federal Reserve warned at the conclusion of its meeting Tuesday, its most bearish outlook in more than a year.

"The pace of recovery in output and employment has slowed in recent months," the Fed said in its statement. It said while it still expects the economy to grow, the improvement will be "more modest in the near term than had been anticipated."

The Fed also announced its plan to buy additional long-term Treasurys. The purchase was seen as moving "one step closer to reinstituting a more aggressive policy," according to a note from Deutsche Bank economists.

Signs of a sputtering U.S. economic recovery have been evident for months, and previous Fed statements have alluded to that growing weakness. Still, Tuesday's statement was seen as the clearest sign of concern yet by Fed watchers.

"The Fed does not appear to view the recent slowing of activity as simply a soft patch in the recovery," said Michael Gapen, economist with Barclays Capital.

As business hiring and household spending have slowed in recent months, there have been growing concerns that the economy is at risk of falling into a so-called double-dip recession, although the Fed did not raise that specific risk in its statement.

As expected, the fed funds rate, the central bank's key tool to spur the economy, remained near 0%, where it has been since December 2008. The rate is used as a benchmark for interest rates on a wide variety of consumer and business loans. A low rate typically spurs spending by making it cheaper to borrow money.

The Fed repeated its outlook of the last 17 months that weakness in the economy will keep the fed funds rate at "exceptionally low levels" for an "extended period."

The Fed has also pumped trillions of dollars into the economy in the last two years through the purchase of assets, including more than $1 trillion in securities backed by mortgages and the debt issued by government-sponsored mortgage finance firms like Fannie Mae (FNMA) and Freddie Mac (FMCC).

The Fed made a modest change in that policy at Tuesday's meeting as it announced it would not allow its balance sheet to shrink as securities reached maturity. Instead, it will reinvest principal payments into long-term Treasurys, concentrating on purchases of 2-year and 10-year Treasurys.

Paul Ashworth, senior U.S. economist for Capital Economics, said the reinvestment announcement is "a largely symbolic gesture, designed to reassure the markets rather than boost the economy." He estimates that it will amount to about $100 billion in additional Treasury purchases a year, a modest amount in the scheme of the Fed's overall holdings.

But the markets were reassured by the move. Major stock indexes, which had been sharply lower before the Fed statement, recouped most of their losses on the news, with the Dow Jones industrial average briefly moving into positive territory on the day. Bond prices rose on the news, driving the yields on the benchmark 10-year Treasury down to 2.74%, the lowest level since December 2008.

Still, some Fed watchers said the central bank can't reverse the growing signs of weakness in the economy on its own.They say the Fed's strategy will have limited impact without further spending by Congress or the private sector.

"I do not envy the Fed's position. Everyone seems to be looking to them to find the answer and they are playing with one hand behind their back," said Kevin Giddis, managing director of fixed income at Morgan Keegan. "The Fed appears to be in the fight and hopefully, after today, Congress will see that their action or inaction could be the difference between a slow recovery and a double-dip recession."

Once again Kansas City Fed President Thomas Hoenig was the lone dissent among policymakers, as he argued the Fed statement and policy limited the central bank's ability to adjust policy when needed.

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